Fiesta Restaurant Group (FRGI) just ended a difficult quarter with comparable growth numbers going distinctively negative. This quarter prompted management to cut the full-year guidance, triggering another sell-off in the shares in what have been difficult times for investors.
I believe, however, that the separation of both chain acts as a serious trigger down the road in 2017-2018 as continuing expansion creates more value on an underlying basis, certainly if comparable growth numbers stabilize.
I think that at these levels there is compelling upside for long-term investors with upcoming triggers next year, even as management appears to handle the current situation somewhat unsatisfactorily.
Fiesta is a restaurant chain operating two distinctive brand chains. The important thing in the investment thesis is that these chains, Pollo Tropical and Taco Cabana, are set to separate in 2017 or 2018.
Spin-offs and divestitures are normally pursued to create more focused companies, which typically should warrant higher valuations. The current plan is to distribute Taco Cabana's stock to investors in Fiesta in a tax-efficient manner.
A Look At Both Chains
Pollo Tropical is the main focus of Fiesta. This Caribbean-inspired chain encompasses 172 restaurants (excluding 37 franchises) on average generating sales of $2.6 million per restaurant. Margins are pretty decent with EBITDA coming in at 25% of sales (note that these are segment margins).
Average check sizes come in at $10-$11 through sale of chicken, fruit juices, rice and beans, among others. Between 2012 and 2015, comparable sales have grown anywhere between 4 and 8% per year, creating challenging comparables to overcome.
The company is rapidly growing this chain, targeting over 30 openings this year, which encompasses nearly 20% unit growth. The vast majority of these locations are located in Florida, although the chain has a growing presence in Texas and other states as well.
Pollo Tropical reported EBITDA of $59 million on a consolidated level in 2015. With corporate depreciation and amortization charges, stock-based compensation and taxes running at $40 million a year, I allocate $20 million of these costs to Pollo. This leaves a clean EBIT number of $39 million, for net profits of $26 million after applying a 33% tax rages.
All in all, Pollo Tropical reported sales of $364 million in 2015, EBITDA of $59 million and estimated profits of $26 million. Given the small unit base and over representation in Florida, there are ample opportunities to grow the company, witnessed by the rapid pace of unit growth.
Taco Cabana offers Mexican-style food, including fajitas, enchiladas, burritos and beer. The Texas-originated chain offers this food at attractive prices with average checks coming in at $9. There are 164 restaurants which on average generate sales of $1.9 million a year, supporting a 19% EBITDA margin.
Taco Cabana posted adjusted EBITDA of $40 million on a consolidated level in 2015. The 50% allocation of $40 million in corporate costs leaves earnings before taxes of $20 million. After taxes this amounts to $13 million a year. Combined with the anticipated profits of $26 million from Pollo Tropical, we arrive at the consolidated reported net earnings of $39 million.
Taco Cabana posted sales of $320 million in 2015. EBITDA came in at $40 million as the cost allocation results in estimated profits of $13 million per year.
What Went Wrong?
At the start of the year, Fiesta guided for low comparable sales growth for both chains. To support continued growth capital spending budgets were set at $90-$100 million, with these budgets requiring a lot of funds as this spending outpaces depreciation charges by a huge amount.
The reality is that the first quarter results were soft, as the second quarter results were not much better. Focused on Texas and Florida, the company has seen headwinds from poor weather and the plunge in oil prices of course.
While unit growth ensured 5.6% revenue growth in the second quarter, the very important comparable sales trends turned negative after growing at a steady pace in recent years. At Pollo Tropical, comparables were down by 1.4% which the company attributes to a 2% cannibalization effect. Taco Cabana reported a 3.8% plunge in comparable with even worse traffic as poor weather had an estimated 1% impact on growth.
Taco Cabana sees huge headwinds from the collapse in oil prices as well as bad weather of course. Worse, comparables for the month of July were down by a serious 5.8%, as discussed on the conference call. For Pollo Tropical the situation looks a bit better, although the results were not good with comparables falling by 1.8% in July.
Following these dismal trends, Fiesta now sees flat comparable growth for Pollo Tropical this year, plus or minus a percent. Sales at Taco are seen down 2%, plus or minus a percent.
The All-Important Valuation
Fiesta now runs the business with a net debt load of $95 million, as I include lease related obligations in this calculation. There are 26.6 million shares outstanding which value equity at roughly $530 million at $20 per share, for an overall valuation of $625 million.
The question is what Taco could be worth on a stand-alone basis. This business is pretty well established and while comparable sales are currently dipping, it is a steady operator. Both Chuy's (NASDAQ:CHUY) and Chipotle (NYSE:CMG) come to mind as competitors, offering similar kind of food. Chu's is valued at $550 million based on revenues of $287 million, although sales could hit $340 million this year. Its restaurant level margins of 21% (EBITDA) are slightly better than the 19% reported by Taco. Chuy's corporate level EBITDA comes in at $45 million as earnings come in around $22 million on an extrapolated basis. This values Chuy's at 1.6 times sales, 12 times EBITDA and 25 times earnings.
Chipotle has its own set of troubles, but remains a very valuable chain. This fast-casual market leader is valued at roughly $12 billion including debt but its sales are falling by double digit percentages for obvious reasons. Even if sales could fall to $4 billion this year, accompanied by very poor margins, it still trades at 3 times sales.
If we use Chuy's multiples to value Taco, it would be valued at $530 million based on sales multiples. Using a similar earnings multiple on the estimated earnings leaves a valuation of $325 million, as the EBITDA multiple suggests a $480 million valuation. If we safely use the lowest number, resulting from the earnings number, we can say that Taco might be worth $300 million.
That would be sufficient to eliminate the net debt load of $95 million, while leaving $200 million in net proceeds — equivalent to $7.50 per share.
What About Pollo?
It is clear that Pollo Tropical is the growth star with strong margins, a good concept and many growth opportunities. It is very hard to come up with suitable competitors for this chain as it is quite unique.
Besides Chuy's there are some other smaller scale operators with market valuations of less than a billion. Zoe's Kitchen (NYSE:ZOES) focuses on Mediterranean cuisine, as Bojangles (NASDAQ:BOJA) is a play on chicken. Zoe's goes for about 2.5 times sales, but is only marginally profitable. Bojangles' sales multiple comes in at 1.6 times, as this leveraged play is much more established.
Sales multiples by other established players are all over the place. While Chipotle trades at roughly 3 times sales, Buffalo Wild Wings (BWLD) trades at 1.8 times sales, as established but slow growing chains like Darden (NYSE:DRI) go for little over 1 times sales.
Given the outstanding performance in terms of unit growth and solid margins, as well as historical comparable growth numbers, I think that a 2 times sales multiple for Pollo Tropical might be fair. With sales approaching $400 million this year, that amounts to a $800 million valuation. While that would result in a steep valuation at 30 times 2015s estimated earnings of $26 million, it is not uncommon given the potential.
If we add this together, Fiesta might be a unleveraged business with a $800 million restaurant chain and $200 million in cash following the spin-off or sale of Taco. That comes in at $37 per share. Even if we assume a more modest valuation of $600 million for Pollo, and subtract another $50 million for the Taco valuation, taking into account the recent disappointments, I see value of at least $28 per share. That still leaves 40% upside from today´s levels.
The sum of the part calculation shows the value being potentially unlocked for investors. The trouble is that the company has run into more difficult times amidst plunging oil prices, poor weather, stiff competition as well as challenging comparable growth numbers. While it is true that earnings have fallen by 11 cents to $0.70 per share for the first six months of the year, this results in a mere 15 times valuation multiple if we annualize these earnings. Given the upcoming trigger and the fairly strong balance sheet, this is not too demanding.
The good thing that a search is underway for a CEO for Taco, as the separation remains on track for the end of 2017, or early 2018. At current levels a lot of bad news has been priced into the stock with shares down two-thirds from their highs.
The continued growth, strong Pollo franchise, upcoming separation and perhaps some management changes all act as potential triggers down the road. I am using this dip to add to my existing position even as the short term results are disappointing.
Disclosure: I am/we are long FRGI.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.